If they build it, what if no one comes?

A throwaway line of mine a couple of weeks ago about the Wellington City Council’s enthusiasm for the proposed airport runway extension prompted a couple of comments here from Tim Brown, chair of Wellington International Airport Limited (WIAL) – owned 66 per cent by Infratil and 34 per cent by the Wellington City Council. As I noted in response to Tim, I was predisposed to be sceptical about the proposal, but would be keen to see the analysis when it was published.

This week a swathe of reports was released, including a cost-benefit analysis prepared for WIAL by Sapere Research Group. The Dominion-Post led with talk of $2000 million of benefits for an investment of $300 million or so, suggesting that there really shouldn’t need to be much further debate about the economic merits of the proposal.

But, of course, any cost-benefit anaIysis is only a reflection of the assumptions fed into it. So I spent some time yesterday reading the report. I had a few questions and observations, and was left unpersuaded that this was a proposal that either my rates or my taxes should be used to fund. Quite possibly, this proposal could offer even worse value than Transmission Gully – as the WIAL report notes, the benefit to cost ratio for that project is only 0.8.

The report proceeds by analysing three options:

Option 1: Build the extension now, to be open from 2020.

Option 2: Build it in 10 years time, to open from 2030,

Option 3: Using the equivalent of the capital cost of the extension instead to promote Wellington airport as a “tourist and airfreight hub” for the next 40 years (the estimated economic life of the extended runway).

The alternative options seem designed to deal with the irreversibility involved in committing now to build now. I’m not convinced that the delay option does that to any useful extent. Will it be any clearer 10 years hence whether a material number of long haul flights from Wellington will be viable? It doesn’t seem quite like a decision on whether to invest in a new technology now, or wait a few years until it is more apparent what the potential of that technology is.

In any case, the bottom line is the estimated benefit-cost ratio for each of the three options.

Option 1 1.7

Option 2 1.6

Option 3 1.4

Even just reading that far into the summary, my eye was drawn to Option 3, and then Option 2, and only finally to Option 1, WIAL’s preference. Why? Well, if a heavy promotional programme could really boost passenger numbers etc as much as extending the runway (as the scenario assumes), why not just go for that. If it works, most of the benefits accrue anyway. And if it doesn’t, the programme is not irreversible and could be canned five or ten years hence. As for Option 2, it delivers almost all the benefits of Option 1, without having to do anything for 10 years.

The report had quite a lot of interesting material about how a longer runway will allow airlines to use aircraft more efficiently than they do now. Load factors will, apparently, be able to be increased on the trans-Tasman flights and a longer runway will also apparently allow landings and take-offs to be done in ways that put less pressure on engines and tires than is the case now. That all sounded plausible enough, but they also sounded like gains that should be able to be captured by WIAL in, for example, its landing charges.

It was a little hard for me to tell – I might have missed something in the tables – but main factor in the success or failure of the airport extension if it went ahead seems to be whether and, if so, how many long haul international flights and passengers would be added. The sceptics’ worry is that if they build it, perhaps no one will come.

The cost-benefit analysis does not look at that scenario at all. It uses traffic volume forecasts and scenarios prepared by another set of consultants. Using Monte Carlo simulation techniques they generate scenarios that are supposed to represent 5th and 95th percentiles around the central forecasts.

Even in the low scenario, international passenger numbers are forecast to grow by 2.5 per cent per annum over the next 45 years in the business-as-usual baseline. Add in the runway extension – and recall that this is the low scenario (the 5th percentile) – they are forecast to grow by 3 per cent per annum. Over 45 years, those cumulate to really big differences: 204 per cent growth vs 278 per cent growth . The consultants estimate that there is only a 5 per cent chance that passenger numbers will fall below these levels. But how credible is that? Shouldn’t we at least see a scenario in which no long haul services use Wellington airport, and the only gains result from the ability of existing operators to use aircraft more efficiently?

One of the puzzling – or perhaps not so puzzling – aspects of the report is the complete absence of any analysis of Christchurch airport’s experience with long haul flights.

The traffic forecasts, prepared by InterVISTAS, involve a central scenario in which in thirty years time there would be 56 long haul departures a week from Wellington (eight per day on average). This is defended with the observation that “Wellington in 30 years time. (FY 2045) will have less than half the number of average weekly frequencies on long haul services as Auckland has now.” And this was supposed to reassure me? In addition to having almost four times the population of slowly-growing Wellington (and a larger hinterland), Auckland is inevitably a more natural gateway to New Zealand than Wellington is. The authors go on to defend their assumptions with the observation that Adelaide has 44 weekly long haul departures (their forecast for Wellington in 2035). But Adelaide is a city of 1.3 million people.

And still no mention of Christchurch. Christchurch has about the same population as Wellington. And if Auckland is one natural gateway to New Zealand, Christchurch is the other, given the much greater tourist appeal of the South Island (and the impossibility of long haul flights into Queenstown). I couldn’t find an easy reference to how many direct long haul flights there are out of Christchurch at present, but there seem to five weekly flights to Singapore. A new service to Guangzhou is also starting this month, so perhaps that is another five flights a week. Other wide-bodied aircraft use Christchurch airport, but to get beyond Australia you still have to stop in Australia.

And it is not as if long haul international flights from Christchurch are relentlessly increasing. I have distant memories of flying direct into Christchurch from Los Angeles, but that was 10 years ago, and the service is long gone. AirAsia’s direct flights from Malaysia to Christchurch didn’t last long either.

Surely it is such an obvious comparator that the Christchurch experience really should have been addressed directly? I can think of a couple of areas where demand for flights in and out of Wellington might be greater than those to and from Christchurch – business and government, and they are probably more lucrative than leisure travellers – but we should have seen the analysis? At the moment, it looks as though the Christchurch story might be a little uncomfortable and so has been quietly ignored. (Canberra comparisons might also have been interesting.)

For a long-lived asset one would normally expect the discount rate used to make quite a difference to the viability of the project. Cash flows far into the future aren’t worth very much if the providers of the capital have a high cost of capital, and thus need a high discount rate to be used.

The main analysis in this report uses a real discount rate of 7 per cent. I am a bit puzzled by that. The authors defend it by reference to the Treasury’s guidance on evaluating infrastructure and single-use building projects (eg hospitals and prisons).

Frankly, I’m sceptical that that is an appropriate discount rate for this project. And I would be astonished if Infratil – the dominant shareholders in WIAL – treated their own marginal cost of capital for a project like this as being as low as 7 per cent real. Perhaps a case might be made for something that low in respect of projects that depend simply on existing traffic (growth) patterns – eg the current extension to the domestic terminal at Wellington – but at the margin this runway extension has the feel of a much higher risk project. After all, they could build it and no one might come. I’ve written previously about government discount rates, and also linked to a recent Reserve Bank of Australia article suggesting that private sector firms are typically using hurdle rates of at least 10-13 per cent nominal (almost as many in the 13-16 per cent range).

However, the report does include some sensitivity analysis. For the central scenario of Option 1 (build the runway extension now), recall that a 7 per cent real discount rate produced a benefit-cost ratio of 1.7. Using a 10 per cent real discount rate only reduces that to 1.6. I don’t understand why that is. Perhaps it is because the capital costs are quite small compared to the additional operational costs airlines would face in putting on the new services (thus many of the costs and benefits are matched in time) but it still doesn’t seem quite right – especially from the perspective of the ratepayers/taxpayers asked to put up the capital cost now.

The report included in its calculation of the benefits to New Zealand the GST paid by the additional foreign visitors. I was a bit puzzled by this, but perhaps I’m missing something. If we assume that the economy is on average fully employed, isn’t it likely that one additional form of exports will be, in part at least, at the expense of some other form of exports? Discovering huge oil deposits, say, will crowd out manufacturing or tourism exports. New Zealand as a whole might be better off, but not to the extent determined just by the increase in one form of exports. Same goes for even high value airport extensions surely?

Many of the gains in the report seem to flow from the additional competition that it is assumed that the longer-runway will make possible. They cite some impressive numbers for how much lower fares are for international routes out of Christchurch or Auckland relative to Wellington. But if we grant that that is a plausible story, again surely this aspect of the extension should be able to be self-financing? For example, if having a longer-runway in Wellington lowered airfares for people from the lower half of the North Island by 10 per cent (the report talks of 20-30 per cent premia at present), surely the airport departure charge for those sorts of flights could be adjusted accordingly? The report spent surprisingly little time discussing such issues/options. Perhaps there are Commerce Commission obstacles to such charging? But if so, surely they should be identified in the report?

While WIAL is a commercial operation, it seems pretty clear that the runway extension does not really stack up on commercial grounds. We aren’t told on what basis Infratil would be happy to proceed with this project – if they really are at all – but the report is clearly written with a political (and voter) audience in mind, rather than a commercial one. Section 2.9 devotes several pages to various sets of central planner objectives – the current Wellington City Council’s 25 year vision, international air transport policy, current central government tourism targets, national infrastructure plan goals, and something chillingly called the “Leadership Statement for International Education”. Not much about the market, or risk and return there. Just the whims of a current set of bureaucrats and politicians, who might be beguiled into using other peoples’ money to proceed with this project.

Perhaps this is too glib, but there does seem to be a relatively straightforward solution. It isn’t obvious why Wellington City Council still holds 34 per cent of the airport. If the project really stacks up for Infratil, it should be a good time for Wellington City to sell its stake[1], and let the private sector go for it. It looks like a pretty risky proposition, but (I’m a bureaucrat by background not a business person and ) if private shareholders want to put their capital behind it then I’m fairly happy for it to proceed (assuming the environmental issues etc can be adequately addressed).

Of course, a common response might be that the putative benefits are national or regional and the costs would fall to the operators of the airport. I’m not persuaded. As I’ve noted, many of the gains documented in the report seem as though they should be able to be appropriated by the airport operator, at least to the extent required to cover its own cost of capital. If airlines can use planes more efficiently, presumably landing rights at Wellington would be more valuable than they are at present? That should be charged for. And if investing in a runway extension really would markedly lower flight prices for Wellingtonians, surely those of us who fly can be charged for the saving? Great projects taken to market by the private sector hardly ever see all the gains captured by the promoters/investors. Bill Gates and Steve Jobs got rich from Microsoft and Apple, but the rest of us did even better as a result and by rather more than we paid for the product.

As it is, the Christchurch experience should be a salutary warning to the citizens and ratepayers, especially those in Wellington. If the initial comments from government ministers seem mildly encouraging (ie discouraging to WIAL), the track record suggests reason for caution even there (this is the government now amenable to funding the Auckland inner city rail loop, and which has been right behind the Christchurch convention centre). As for Wellington City Council, the sceptical comments from Greens councillor David Lee notwithstanding, I wonder what will stop these planners pursuing their vision, egged on by the Chamber of Commerce? What lessons have they taken, for example, from the disaster of the Dunedin stadium? I hope that, at very least, no binding commitments are made by the council until after next year’s local body election.

To their credit, WIAL is holding a series of lengthy public sessions in the next couple of weeks at which apparently their experts will be available to answer questions. If I have time I will try to go along, and if any of my concerns are materially assuaged I might come back to the issue later.

[1] To which my only caveat would be a concern about what even lower-value projects they might use the resulting cash for instead.

Will look forward to your post. But their 45% was already well below what they report as MBIE’s recommendation, and value-added (not profit) of 10% does seem implausible (and even at 10% the BCR is still 1.3%). Having said that I’m still uneasy about the gen equilibrium story – the increase in value-added in tourist spend will be partly offset by reductions in other activity, It is only a gain to NZ if the new activity is higher productivity/higher price than what it displaced (generalising my point about GST)

Central government should do a calculation of the potential savings to them for overseas travel, particularly to Asia/Europe if they no longer needed the WGN-AKL leg. Auckland-Singapore was a well traveled route for me when in working for them. Let them then part fund it and/or purchase the WCC shares.

Hi Michael, thank you so much for this excellent post. It is very heartening that someone of your background credential raises similar issues to us around the economic analysis and forecasts of this proposal. We would love to hear more from you on this issue! Dr Sea Rotmann, Co-Chair Guardians of the Bays

Laddie – after a hellraising landing this afternoon during which my airbus A20 B*&^dy nearly overshot the &^%$ runway in this ridiculous Wellington weather i get into my taxi and start reading your blog only to hear you are going on about the non existent economic benefits of extending the runway. We love you to bits Michael but we DO need a longer runway purely so the darn aircraft can land safely. I couldn’t give a continental about Mr Brown’s RoE!!!!!!!!
Merry Christmas to you and the family.
George

“The traffic forecasts, prepared by InterVISTAS, involve a central scenario in which in thirty years time there would be 56 long haul departures a week from Wellington (eight per day on average).”

This seems optimistic (optimism bias).

With the arrival of China Southern direct to CHC & Air NZ seasonal flights to Perth + China Airlines there will be 18 summer departures (SIN=7 + CZ=3 + NZ=2 + CI=6) per week. One assumes WLG is likely to be a similar size market as CHC given the similar regional population bases & trade off between government & tourism trips in the 2 airports.

Stats NZ population growth through to 2043 is roughly 30%. (Assume departures grow by a similar amount). 18 departures * 1.3 = 23.4 per week.

To get to 56 (assuming the latent demand of 18 in WLG & my est of 23.4 in 30 years) is +32.6 (56-23.4) more departures per week needed in 30 years than estimated above.

Even doubling the 30% growth to 60% to allow for technological change and newer more efficient aircraft types to service WLG & CHC = approx 29 weekly departures or say 4 per day (rather than 8 per day used).

To get to 56 we still need to roughly double the above estimate.

This would say need Emirates to also fly trans tasman into WLG & conversion of at least 3 other existing daily trans tasman flights to wide body aircraft to meet demand. (Seems to be about 8 existing trans tasman flights, at least on a Saturday)

One option is for the backers of this project to be asked if they would be prepared or able to refund the funds if they don’t meet their targets in years 1, 2 and 3. That seems a prudent decision and I assume the backers would be happy to accept, unless of course they’ve misrepresented the benefits.

It would mean that those providing the funds wouldn’t be out of pocket if the deal turned sour. How realistic is that?

A majority privately owned business like the Wellington airport is a high risk investment for the government as there is no promised return on that investment to the taxpayer. It is a gift subsidizing the profit of a privately owned business. If Wellington airport needs $150 million they should go through the normal business process of capital or debt raising either the offering of shares and ownership in exchange for that $150 million or borrowing from the bond market. The same applies of Wellington Council’s contribution of rate payer funds should be exchanged for higher ownership or as a interest bearing loan.

It does not look like anyone is coming when there are these major safety concerns over the length.

“The New Zealand Air Line Pilots Association says a run-off area for larger plans the airport hopes to attract by extending the runway is not long enough.

The “runway end safety area” should meet internationally recommended standards of 240m not the 90m that has been signed off by the Civil Aviation Authority as part of a historic dispensation, said the association’s technical director Captain Rob Torenvlied.”